Overview : European Agreement On The Bail-In Rules

The heads of state and government of the 27 European Union countries met on 27 and 28 June in Brussels for another summit devoted to European economic and financial policy. The major challenge facing the summit was to make progress towards achieving banking union. The commitment made exactly one year ago at an identical European summit in all likelihood brought a turning point towards resolving the crisis, with Mr Draghi’s announcement of the creation of the Outright Monetary Transactions programme a few weeks later.

Since then, one agreement had only been reached, enabling the European Central Bank (ECB) to run a single supervisory mechanism covering the largest banks in the euro zone and those receiving support from the European Stability Mechanism (ESM), probably from September 2014. It was becoming critical not to allow the feeling to persist for any longer that decisions concerning the other pillars of banking union would be pushed back time and time again. Aside from the implementation times, the challenge is also to ensure that the agreements reached take integration far enough to allay investors’ fear that difficulties facing one or more banks will jeopardise the solvency of a whole country or vice versa.

Bail-in and resolution
The text finalised this week, which has to be approved by spring 2014 towards the implementation in 2018, aims to curb the burden falling on taxpayers by having shareholders, as well as creditors and depositors other than individuals and small businesses, also take a share of the losses. Alongside resolution tools such as the sale of businesses, the creation of a bridge bank to hold healthy assets and defeasance, bail-ins enable the resolution authorities to eliminate or convert certain deposits or loans to a failing institution into equity. Beyond the harmonised threshold for guaranteed deposits set at €100,000, the Council of Europe’s agreement has given certain depositor categories (individuals, SMEs, funds provided by the European Investment Bank) a higher ranking than that of other creditors and depositors (such as large corporates). Furthermore, once subrogated to the rights of the guaranteed depositors that it has shielded, the guarantee fund will also enjoy a higher ranking than that of the preferred unsecured depositors.

National resolution authorities may use the resolution fund to absorb losses or inject fresh capital into an institution only after initial losses representing at least 8% of the bank’s liabilities have been covered by shareholders and creditors. Beyond this level, an amount of up to 5% of the bank’s liabilities may be drawn from the resolution fund. Should the losses exceed 13% of the liabilities, the residual losses may be absorbed by creditors and non-guaranteed and non-preferred depositors before alternative sources of funding (government, then the ESM) are called upon as a last resort.

Direct capital injections by the ESM: possible, but only as a last resort
At a Eurogroup meeting, the euro zone finance ministers (also the directors of the European Stability Mechanism) agreed last week on the conditions under which the ESM may in the future be able to play a direct role in recapitalising an institution that has run into difficulties. The mechanism, about which several Member States have reservations, is clearly intended for use only as a last resort and subject to strict rules.

Shareholders and private creditors will be the first to be called upon to contribute to turning around the fortunes of the relevant institution in line with aforementioned rules. If a public bail-out still proves to be necessary, the ESM may intervene directly only at the request of a Member State stating that it is unable to provide the requisite funds on its own without endangering the sustainability of its public finances or its market access. The relevant institution will also have to be a systemic bank, and the difficulties it faces must threaten the euro zone’s financial stability. In principle, the ESM will take action only jointly with this Member State, which ensures that countries will have an incentive to curb the use of public funds as far as possible. To take the problem of legacy assets into account, the minimum contribution from the Member State will be larger when the mechanism is first implemented. It will be at least 20% of the total public funds injected during the first year, then 10% in the second, before being reassessed by Eurogroup members.

The decision to grant assistance will be taken by mutual agreement of the ESM governors. The Eurogroup has not ruled out retrospective use of this instrument (Spain and Ireland are clearly in the running), which theoretically will not include the ESM toolbox until the single supervision mechanism starts up in late 2014. This may be decided “on a case-by-case basis”. Compared with the other instruments available to the ESM (loans to governments, purchases of government bonds), establishing a direct interest in the capital of banks nonetheless appears to carry a far higher risk profile. To protect the mechanism’s lending capacity, as well as its credit rating (the ESM borrows the funds it lends in the markets), the Europeans have agreed to cap the funds allotted to this instrument at EUR 60 billion.

BY Frédérique CERISIER , Laurent QUIGNON